Steven A. Branson, Esq. - Financial Strategies

As predicted, last minute tax legislation extended certain provisions.

One is the ability to deduct the greater of state sales or state income tax on Schedule A. This means that there is still time to make big ticket purchases if the sales tax will exceed the income tax paid for 2006. This deduction is also available for 2007, so a big ticket purchase will make more sense next year of the state tax paid will be less.

Another is the above the line education tuition deduction, which remains subject to income limits (it is phased out for joint AGI of $160,000), and cannot be used in the same year as the Hope or Lifetime Learning Credit. If you are under the phase out limit, paying spring tuition now may make sense.

The new law extends the $250 above the line deduction to teachers for out of pocket expenses through 2007. Any amount above $250 may be claimed on form 2106.

The new law allows for roll overs to Health Savings Accounts from flexible spending accounts, health reimbursement accounts and, for a once in a lifetime roll over, IRAs. The limit on annual contributions is also repealed.

The new law extends the 30% credit of up to $2,000 for solar water heaters, solar electricity equipment and fuel cell plants through 2008.

The new law creates an AMT credit for up to 20% over five years for unused AMT credits from the exercise of ISOs. However, this new rule has an adjusted income cap of $234,600.

The new law creates an itemized mortgage insurance premium deduction for 2007 for AGI below $100,000.The new law establishes capital gains treatment for self created musical works.

Let us know if you have questions on any of these changes (and see year-end tax planning for ideas for later this year).

The IRS announced a deduction for 2006 tax returns as a refund for federal taxes paid on long distance bills. The standard amounts are $30 for a person filing a return with one exemption, $40 for two exemptions, $50 for three exemptions and $60 for four or more exemptions. For example, a married couple filing a joint return with two dependent children (for a total of four exemptions) will be eligible for the maximum standard amount of $60.

Congress passed a new law to strengthen pension plans. This new tax law also made certain changes enacted with the 2001 tax law permanent, including:

• You can contribute up to $4,000 to an IRA, which becomes $5,000 in 2008 and will be inflation-adjusted thereafter. If you are age 50 or older, you can add a $1,000 catch-up contribution;
• You can contribute up to $44,000 to your plan if you are self-employed;
• You can contribute up to $15,000 to a 401(k) plan, with an additional $5,000 catch-up contribution if you are age 50 or older;
• You can contribute up to $10,000 to a SIMPLE plan, with an additional $2,500 catch-up contribution if you are age 50 or older;
• Roth 401(k) and 403(b) plans were available to employers before, but they are more likely to be offered now that they are permanent. (Employers were wary of the cost involved in maintaining the plans if the plans were to be only temporary.) An employee will now get to decide whether to invest in the standard 401(k) plan, with pre-tax funds, or the Roth 401(k) plan, with after tax funds but where the distributions are not subject to income tax at retirement; and
• Withdrawals for college from 529 plans now remain sheltered from income tax after 2010, which is consistent with our advice for clients with younger children to contribute to 529 plans.

The new law redefines certain rules for charitable deductions:

• Used clothing and appliances need to be deemed “in good condition” to be eligible. The IRS has not yet defined good condition;
• For single items valued above $500, an appraisal is required to receive a deduction;
• Deductions are allowed for cash donations only if the donor can show a written statement attesting to the amount of the contribution, the date the contribution was made and the name of the charity;
• The new law allows taxpayers to make tax-free distributions of up to $100,000 from IRAs for charitable purposes through December 31, 2007. The distribution is excluded from taxable income so you skip the step of getting funds from an IRA, having that amount taxed, and then taking the deduction. This is good as Schedule A deductions are reduced above a certain level, so you would lose part of the deduction value.

A taxpayer may roll over his or her deceased spouse’s interest in a qualified retirement plan, government plan or tax sheltered annuity into IRA. This is now also available for non-spouse beneficiaries (which aids same sex couples).

You can directly roll from a plan to Roth IRA, where before you had to roll from the qualified plan to an IRA and then to a Roth IRA.

Refunds from your tax return can now be split and deposited into three different accounts.

Congress cannot agree on the terms of a new law, either in terms of the unified credit amount or the tax rate. Therefore, change is unlikely this year.

TIPRA (see earlier posts) includes an increase in the “kiddie tax” to children age 14 to 18. This makes the use of UTMA accounts and certain trusts less favorable. However, it also makes use of 529 plans more favorable as they are not affected.

The elimination of the cap on Roth Conversions after 2009 makes contributing to non-deductible IRAs now more favorable. This way, you can build up an IRA that you later convert with minimal tax cost to a Roth IRA from which all distributions are tax free. The tax on conversion in 2010 can be paid over 2 years, where the best strategy is to pay that tax from assets outside the plan.

The IRS announced that it will stop collecting the excise tax on long-distance calls. Furthermore, there will be a refund of this 3% tax available when you file your 2006 income tax returns.

Congress passed the Deficit Reduction Act of 2005 in February of 2006. This law makes access to Medicaid more difficult by:

1. extending the general look-back period from 3 to 5 years,
2. delaying the start of the penalty period for transfers of assets within that period,
3. limiting the amount of home equity that can be excluded,
4. making a mandatory designation of your state as the contingent beneficiary of any annuities you own,
5. requiring a mandatory shift of income from the nursing home spouse to the healthy spouse, and
6. changing the test on when investment in an annuity is an excluded asset. The law has raised concerns that charitable donations, payment of college tuition for children or grandchildren, and gifts to children may be reachable by the state. Some also believe that children may become responsible to the state for their parent’s care.

The new Roth 401(k) plan combines features of Roth IRAs as discussed above with the features of a regular 401(k) account. Employees can contribute after-tax dollars to their retirement funds from salary in place of, or as part of, their plan contributions. The after-tax contribution can later be withdrawn tax-free.

The contribution limit is the same as the traditional 401(k) limit, which is substantially higher than the Roth IRA limit. Also, participants in 401(k) plans often are excluded from also making Roth IRA contributions.

When an employee leaves his company, he can roll the Roth 401(k) account into a Roth IRA, continuing the tax deferral and avoiding the minimum required distributions of traditional IRAs that begin at age 70½.

To decide if the Roth 401(k) is better for you, you need to decide that forgoing the tax savings now (and thus having less take-home pay) is better than paying taxes on the traditional 401(k) distributions at retirement. If you believe that future tax rates will be higher for you in retirement, then the case becomes more compelling. Of course, if the plan allows, you can hedge the decision by participating in both Roth and traditional 401(k) accounts. Note that the new plan will only be in effect until 2011.

New Tax Law and Related Planning: Congress passed the Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”) last week. Principally, this law provides $70 billion in tax cuts consisting largely of extending the dividend and capital gains tax rate cuts for two more years beyond 2008, the original expiration date. The law also provides some relief from the Alternative Minimum Tax (“AMT”). The law eliminates the cap on converting IRAs to Roth IRAs for one year, allowing the resulting taxes to be paid over two years. The taxes anticipated from conversions are part of the $20 billion of revenue increases used to offset the revenue loss from other provisions. Some provisions originally proposed were removed from this bill but may appear in future bills, including items such as extending the state sales tax deduction and teachers’ expense deduction.

Capital Gains and Dividends – The 2003 lowering of the tax rate on long term capital gains and dividends was set to expire in 2008. TIPRA extends these rates until 2010, which lessens any pressure to sell stocks by 2008. AMT relief – TIPRA increases the exemption for the AMT to $62,550 for joint filers (from $58,000 for 2005) and to $42,500 for single files (from $40,250). The change seems small but will save 15 million people from the AMT. We had anticipated this possibility when doing year-end planning in 2005, shifting deductions to 2006. Now, those deductions need to be used because the new law increases the exemption for one year only. Planning for 2007 will be different.

Roth Conversions – The $100,000 cap on Roth conversions is lifted after 2009, and the taxes due on conversions can be paid over two years. Eliminating the cap would allow high income filers to shift from IRAs, where distributions are taxed, to Roth IRAs, where there is no tax on distributions and no requirement to begin minimum distributions at age 70½. If the income tax rates will be higher after 2010, as many predict, paying the tax in 2010 may make sense. This is especially true if the tax is paid with money outside of the Roth IRA so that thee maximum amount can be rolled over.

“Kiddie” Tax – Currently, children under age 14 are required to pay tax on unearned income in excess of $1,700 at their parents’ marginal tax rate. TIPRA increases the age to 18, subjecting more children to their parent’s tax rate. For families planning to sell assets in a child’s name at the low tax rates before he or she enters college, Congress has now frustrated that plan.

The Commonwealth has repealed the tax that was to be assessed for 2002 up until April 30 and will provide refunds capital gains after April 30. Information on the Department of Revenue abatement application procedure will be provided on their website at www.mass.gov/dor.

Owner of an income interest in a Charitable Remainder Trust may be able to sell that interest now to create liquidity, rather than continuing to receive the stream of payments from the trust. The amount the beneficiary receives could be taxed at long-term capital gains rate, as an income interest held more than 12 months and then sold. The decision to sell the interest then turns on the valuation of that stream of payments by the buyer against the need for current liquidity.

Bonds are likely to show little if any returns for several years because interest rates continue to rise. On the other hand, energy prices have had a tremendous run recently. There are ways to take advantage of some commodities but, as Vanguard has pointed out, the S&P 500 Index fund has nearly 9% of its assets devoted to energy stocks, so that is sufficient for most investors. If you want to discuss ways to hedge on commodities and climbing interest rates, let us know.

Some people say “You can’t lose with real estate” and other say “There a real estate bubble ready to burst” – Who is right?

In the end, what you get out of your house rarely matches what you get from your retirement plans.

Often in a divorce, one person wants to retain the home, either for sentimental reasons, as a consistent living space for children, or because they believe that the home offers the greatest appreciation. That last assumption may not be correct, and there are other issues that a divorcing couple should consider in dividing assets.

To put the issue one way, before you decide that you want to keep the house in a divorce and give up retirement plan accounts, ask your self if you plan to sell a bed room when a child needs money for college tuition or when you need money at age 65. Holding the bulk of your assets in your home means you have your net worth primarily in one location, which is not diversified, and that asset may not offer the best investment returns.

Psychologically, people assume that the homes have been appreciating so they will continue to appreciate. However, you do not get hourly quotes on Bloomberg for the value of your home. In fact, house prices have fluctuated over time. For example, if you purchased a house in the late 1980s, the value went down and did not return to what you paid until the early 1990s.

If you compare the price change over a 10-year period of property, even excluding all the costs to operate, maintain, and improve the property, real estate does not usually match the returns of the S&P 500, which has no carrying and maintenance costs.

True, the returns on real estate are better when you look at how much your equity increased. For example, a house purchased in 1992 for $350,000 might be worth $700,000 today. If you put 20% down, $70,000 in cash, the equity today of more than $350,000 (depending on how much of the mortgage was paid off) is a 5-fold return. However, when you account for the costs of the after-tax mortgage and the property taxes, the cost of repairs, maintenance and any improvements, the return may come down. Thirteen years of mortgage payments and property taxes alone could be over $180,000, assuming a 30% tax rate, maintenance could be another $20,000 or more and, to maintain the value of the house, as much as $100,000 of improvements may have been mandated. Now the cost is $370,000, including original down payment, and the current value of the equity is $350,000. This return is actually negative, while the stock market, represented by the S&P500, produced a 4-fold return. If your property paid you rent to cover the carrying costs, it would behave more like an investment. However, because you live in it, and pay the costs for that comfort, a house is really a “lifestyle” asset rather than an investment.

If the “death tax” is repealed, charities stand to lose roughly $10 billion a year, according to the Brookings Institution and the Urban Institute. This amount is nearly equal to contributions by the country’s 82 largest foundations for 2003. If the federal estate tax is eliminated, there is no need for charitable remainder trusts, charitable lead trusts or bequests to charities. Nonetheless, charities are not lobbying against the repeal because they do not want to alienate the wealthy. (For more estate taxes, see the April 22 update.)

Social Security Entitlements: The proposals to “fix” Social Security address the transition from today, when current worker contributions still fund benefits to present retirees, to sometime after 2040, when there will be a short fall as the inflow will be less than the promised benefits. (In fact, Social Security has had a surplus that it lends out, but that in turn causes budget problems to pay interest and principal on that loan.)

There are several alternative solutions proposed. President Bush wants to “privatize” individual accounts, in hopes that stock market returns will make up the short fall. However, many future beneficiaries may be unwilling to take this risk or may take the risk and lose money. This could therefore exacerbate the problem. Another solution is to remove the cap on FICA taxes to provide more funds so there will not be a short fall. This is unlikely to pass as many oppose the increased tax. Another solution is to reduce future benefits. This is a likely outcome, but not a popular one, as social security has been considered an entitlement for generations. We will keep monitoring this issue for future developments.

Income Taxes: Many found that they had to pay the Alternative Minimum Tax or AMT this year. Some describe this as a stealth tax, hitting 2.9 million taxpayers with an average of $6,000 over the regular tax for 2004. (The AMT could hit 18 million people by 2006.)

This answers the cynics who predicted that the Bush administration, plagued by budget deficits, had to eventually raise taxes. With a 28% bracket, the AMT is complex and nearly impossible to calculate without the aid of software. It was created in 1969 and has not received the same inflation adjustments that have been given other tax provisions. (For strategies on avoiding the AMT, see the March 22 update below.)

Home office: The use of a dedicated space as a home office received more favorable treatment from the IRS over the last few years. If you run a business from your home, you can deduct the allocable portion of utilities, insurance and repairs, as well as property taxes and mortgage interest. The IRS also requires that you depreciate the home office. Thus, you get a tax benefit now but when you sell your home, that depreciation comes back as a taxable capital gain.

Estate taxes: The current federal credit is scheduled to rise to $3.5 million in 2009, the estate tax then disappears for the year 2010, and then the credit falls back to $1 million. President Bush wanted to eliminate the “death tax” but does not have the votes. What seems more likely to pass Congress is a permanent increase in the credit so that estate under $5 million or so will not be taxed. We will update you on this when something more formal occurs.

Investing: Interest rates have continued to rise, so that long-term corporate bonds now pay more than CDs with similar maturities. People holding cash should consider cautiously moving into bonds with intermediate maturities. At the same time, cash available for investment should also be added to international funds if you do not presently have an adequate allocation.

Globalization has been a topic recently, with some calling it a gale of creative destruction. On the one hand, it adds to the market for many companies and permits better sharing of resources. On the other hand, it threatens jobs and pay for US employees and some companies may not survive the competition. How does one respond? At the business level, it is the face-to-face economy that cannot be reduced to computer rules and will remain strong in the US. Relationships built on trust, befriending clients and understanding them rather that commoditizing what they do will succeed. To go further, one source suggests that businesses have to be more socially responsible and ethical because (1) customers will pay more, (2) employees will support this approach, and (3) shareholders will be more loyal.

As for your personal response, with the US 25% of the world economy, your investments portfolio should be diversified by investing abroad.

Investment Allocation: Your portfolio should have an allocation to international stocks. This is not just as a play on any further decline in the dollar; there are many good investments overseas so you diversify further with an international allocation.

Real Estate Investing: Many investors consider purchasing real estate. Doing so makes you a landlord, with the resulting headaches. As with any other investment, you need to do your homework. If you can purchase a property where the rent covers your after-tax cost on mortgage payments, property taxes, insurance, repairs, and a reserve for future capital improvements, then the investment may be attractive. In reviewing your projections, you should allow for vacancies just to be conservative. You should also consider the impact of rising mortgage rates.

Important: If you have not updated your estate plan for state de-coupling from federal law, you need to do so. Also, make sure you name people rather than trusts as beneficiaries of your qualified plans, so that the pay out to survivors can be over their lifetimes, rather than a set five years.

In December, you can review your credit report once per year at no cost. This review is important to make sure that there are no errors or, worse, that no one has found access to your information. You can order reports now for $9 from Equifax (800-685-111), Experian (888-397-3742) and TransUnion (800-888-4213). If you find errors, report them to these bureaus, the reporting creditor and the Federal Trade Commission, using certified mail. Check back to see if the errors were corrected.